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Home / ... / Accounting for Impairments A Practical Guide

Accounting for impairments of non-financial assets can be a minefield even for the seasoned professional as IAS 36, Impairment of Assets is one of the more complicated accounting standards. This makes getting the accounting and disclosures right more of a challenge. Derarca Dennis, Senior Manager, PricewaterhouseCoopers, outlines aspects of IAS 36 that should be considered when preparing for the 2008 year end.

The last 12 months have been marked by unprecedented volatility in global markets and signs of economic downturn. These market conditions will cause many companies to revisit their business plans and revise financial forecasts. As a result of these changes management may experience significant impairment charges in the coming months.

The basic principle is that an asset may not be carried in the balance sheet at more than its recoverable amount. An asset’s recoverable amount represents its greatest value to the business in terms of the cash flows that it can generate. That is the higher of: - The amount for which the asset could be sold in an arm’s length transaction between knowledgeable and willing parties, net of costs of disposal (fair value less costs to sell); and - The present value of the future cash flows that are expected to be derived from the asset (value in use). The expected future cash flows include those from the asset’s continued use in the business and those from its ultimate disposal. Value in use (VIU) is explicitly based on present value calculations.

This measurement basis reflects the economic decisions that a company’s management team makes when assets become impaired – is the business better off disposing of the asset or continuing to use it? What follows are some aspects of applying the standard that should be considered when preparing this year’s calculation.

‘Reasonable and supportable’ The assumptions used in arriving at the recoverable amount need to be ‘reasonable and supportable’ regardless of whether impairment calculations are based on fair value less costs to sell or value in use. The acceptable range for such assumptions will change over time and forecasts for revenue growth and profit margins are likely to have fallen in the last 12 months. Discount rates may have risen too as risk premiums rise. Have the assumptions been reviewed and changed to bring them up to date? Are the assumptions made by management in line with the assumptions made by industry commentators or analysts? Variances from market will need to be justified and highlighted in financial statement disclosures.

What type of impairment calculation? The calculations of recoverable amount based on fair value less costs to sell or value in use differ. A common error is to describe the calculation as being on a value in use basis but then include in the forecast cash flows the costs and benefits of future reorganisations and enhancement capital expenditure. Both of these are prohibited from inclusion in a value in use calculation. They could be included in a fair value less costs to sell calculation if the reorganisations and enhancement capital expenditure are consistent with the assumptions that other market participants would make.

Does the answer look sensible in the current market? Whatever method has been used to calculate the recoverable amount, the number produced by the model needs to be considered in the light of available market evidence. The old computer-related adage of ‘garbage in, garbage out’ also applies here. The simplest test to perform is to compare the values implied by the valuation models with current share prices or prices achieved in recent market transactions. Clearly, where a direct market price is not available, alternative data may need to be reviewed, such as market prices for comparable entities. Where evidence is available from market data relative to total valuations or key assumptions, it should not be ignored. Where other entities in the same sector are taking impairment charges, the absence of an impairment charge should be carefully investigated and justified – not least because the market will be asking the same question.

How do I test goodwill? The level at which goodwill is tested depends on how it has been allocated to cash-generating units (CGUs). If goodwill has not been allocated to individual CGUs, as is often the case, but is monitored at a higher level, a two-stage impairment test is required.

Firstly, impairment testing is performed at individual CGU level, comparing individual CGU recoverable amounts with the assets that have been directly allocated to the CGU (for example, a retail store for a retailer). Any impairment identified at this level is allocated to the fixed assets being tested. Secondly, the recoverable amount of the group of CGUs to which goodwill relates is compared with all of the assets of those CGUs plus the goodwill. At this second stage, any impairment is charged against goodwill until that is exhausted.

Watch out for the disclosures The IAS 36 disclosures are extensive. What follows is not a comprehensive list; it is a reminder of the main areas that need to be disclosed. Required information where there is an impairment arising includes impairments charged, identification of which CGUs have been affected by impairments and discount rates applied. Even where there is no impairment, certain assumptions have to be disclosed (notably long term growth rates and discount rates), and the identification of key assumptions and the approach to determining them is required. Where a reasonably possible change in a key assumption would give rise to an impairment, additional extensive sensitivity disclosures are required. These include the quantification of all the key assumptions, by how much they would have to change to remove all of the headroom, together with the headroom currently shown by the calculations. As headroom reduces due to deteriorating market conditions one can expect to see considerably more sensitivity disclosures in 2008; also the range of reasonably possible changes in many key assumptions will increase as market volatility increases.

Regulators around the world have indicated that they are going to focus on impairment disclosures in 2008. What to do now? Simply put, start the process early. Goodwill has to be tested annually, but the standard allows for goodwill to be tested before the year end to assist companies with the complicated and time-consuming process. Remember, though, that goodwill and other assets need to be tested when there is a trigger event. Notwithstanding the risk of a trigger post the goodwill testing, getting a head-start on the process will identify problem areas early and avoid a late rush and unwelcome surprises during the latter stages of the year-end process.

Derarca Dennis is a Senior Manager in the Accounting Consulting Services of PricewaterhouseCoopers. Email: derarca.dennis@ie.pwc.com

Good article